The drafting of discretionary trust deeds and NSW duty and land tax
In recent times most NSW trustees have become tired of the many tax reforms that have affected trusts and which have required amendments to their trust deeds. These reforms include the introduction of the concept of a fixed trust for NSW land tax purposes in the mid 2000s and the introduction of the trust streaming provisions in 2011 as a response to the High Court case of FCT v Bamford  HCA 10.
Now, the introduction of land tax and duty surcharges on foreign persons (including trustees of discretionary or hybrid trusts which have foreign persons within the class of potential beneficiaries) has triggered the need to review those trust deeds again.
As part of the 2016 NSW State Budget the NSW government introduced two measures aimed at foreign investors in NSW residential land, namely:
- a 4% surcharge purchaser duty where a foreign person acquires NSW residential land on or after 21 June 2016, and
- a 0.75% surcharge land tax where a foreign person owns NSW residential land at 31 December in each calendar year.
The surcharge land tax applies to a foreign person without the benefit of any tax-free land tax threshold or principal place of residence exemption.
These surcharges are on top of the usual duty and land tax payable and materially increase a foreigner’s property costs as compared to an Australian:
|Rates of NSW duty and land tax||Australia||Foreigner|
|Premium property duty (residential land > $3,000,000)||7%||11%|
|Premium land tax (residential land > $2,947,000)||2%||2.75%|
What is the problem for Australian discretionary trusts?
The definition of a ‘foreign person’ for these measures is drafted widely and can include discretionary or hybrid trusts which are ostensibly intended to benefit Australian beneficiaries! This is so even though the measures are targeted at foreigners.
Who is a ‘foreign person’ for surcharge purchaser duty and surcharge land tax?
A ‘foreign person’ for these purposes means a person who is a ‘foreign person’ for the purposes of the Foreign Acquisitions and Takeovers Act 1975 (Cth) (FATA) but with two modifications relating to Australian and New Zealand citizens. Broadly, a ‘foreign person’ for these purposes is defined to include:
- an individual not ordinarily resident in Australia
- a corporation or a trustee of a trust in which an individual not ordinarily resident in Australia, a foreign corporation or a foreign government holds a substantial interest (at least 20%)
- a corporation or trustee of a trust in which two or more persons, each of whom is an individual not ordinarily resident in Australia, a foreign corporation or foreign government holds an aggregate substantial interest (at least 40%)
- a foreign government, or
- a person prescribed by the FATA regulations as such.
An individual is ‘ordinarily resident in Australia’ if they have been in Australia for 200 or more days in the 12 months preceding the test time and at that time their continued presence in Australia is not subject to any legal limitation.
However, a ‘foreign person’ for these purposes does not include:
- an Australian citizen regardless of where they reside, or
- a New Zealand resident who holds a special category visa under section 32 Migration Act 1958 (Cth) (usually this a New Zealand resident who presents their New Zealand passport at customs and is not a behaviour concern non-citizen or health concern non-citizen), and has been in Australia for 200 or more days in the 12 months preceding the test time.
The test time for purchaser duty surcharge is the date of first execution of the purchase contract (although there are some transitional provisions that relate to contracts arising from options granted before 21 June 2016) and the test time for land tax surcharge is 31 December of the relevant year.
The problem for discretionary and hybrid trusts arises from the rules that determine whether a foreign beneficiary holds a ‘substantial interest’ in the trust. Section 18(3) FATA provides that in working out the extent of a beneficiary’s interest in a discretionary trust, each beneficiary is taken to hold the maximum percentage of income or property of the trust which the trustee may distribute to them. Effectively this means that each discretionary beneficiary is deemed to hold 100% of the beneficial interests in the trust and hence hold a substantial interest for the purposes of the ‘foreign person’ definition.
Even more problematic is the ‘associates’ test. Even if the rights of any single foreign beneficiary was limited to 19.9% (and the rights of foreign beneficiaries in aggregate were limited to 39.9%), the trust would still likely be characterised as a ‘foreign person’. This is because the interests of the beneficiary are aggregated with interests held by associates of that beneficiary. In a standard discretionary trust deed, it is likely that most discretionary beneficiaries will be ‘associates’ of the default beneficiaries and therefore any interest held by a foreign discretionary beneficiary (however small) is likely to be aggregated with other interests held by non-foreign beneficiaries, resulting in a substantial interest.
This obviously creates significant difficulties for traditional discretionary trusts and certain hybrid trusts that have wide beneficiary classes. Having just one foreign person beneficiary is generally enough to cause the trust to be classed as a foreign person and potentially subject to NSW purchaser surcharge duty and surcharge land tax. In these modern global times where family members may be scattered around the world, this result may not be uncommon. For instance, consider a discretionary family trust established by a father and mother for the benefit of their immediate family who are all Australian citizens. The trust’s beneficiary class is, however, drafted to include a wide range of family members. Let’s say a younger son relocates overseas for work, marries a foreigner and continues to live in that foreign country. Whilst the younger son may still keep his Australian citizenship, his spouse may not be an Australian citizen and their automatic inclusion in the trust’s beneficiary class is enough to cause the trust to be a ‘foreign person’ for surcharge purposes. This is so even if the trustees (being the father and mother) have no intention of ever distributing anything to the spouse!
There is no legislative carve out or discretion which would allow the trust to not be a foreign person, even though ostensibly it is an Australian trust and the policy of the surcharge measures is that they apply to foreigners.
What is ‘residential land’?
The purchaser surcharge duty and land tax surcharge applies to NSW ‘residential land’ which for these purposes covers:
- land on which there are one or more dwellings or land on which there is building construction that when completed will constitute one or more dwellings
- a strata lot, if it is lawfully occupied as a separate dwelling or suitable for lawful occupation as a separate dwelling
- a utility lot if its use is restricted to the owner or occupier of a strata lot mentioned above
- a land use entitlement if it entitles the holder to occupy a building or part of a building as a separate dwelling (e.g. company title shares), or
- vacant land zoned or designated principally for residential purposes.
Commercial residential premises and primary production land are not ‘residential land’ for these purposes.
The scope of purchaser surcharge duty is wider than just acquisitions of residential land by foreign persons. The duty legislation imposes the purchaser surcharge duty on transactions involving residential-related property. This covers nominations and assignments of options over residential land and also transfers of partnership interests that include residential land. The purchaser surcharge duty may also apply in the context of landholder duty where NSW residential land is involved.
Is there a fix?
Where a discretionary or hybrid trust is only ever intended to benefit Australians and there is a possibility that the trust may be a foreign person because of the existence of a foreign discretionary beneficiary, trustees should consider amending their trust deeds (or drafting their new trust deeds) to confine the discretionary beneficiary class to persons who would not cause the trust to be a foreign person for surcharge purposes. The required amendment is not extensive and in light of additional duty and land tax (otherwise payable) should pay for itself quickly in time. This is particularly so, since surcharge land tax is a continuing annual cost. Based on case law the amendment should not trigger a resettlement of the trust, however, care needs to be taken in undertaking the amendment. This is because not all trust deeds have variation powers that are wide enough to make such an amendment. Appropriate legal advice should be obtained in this respect.
If the discretionary or hybrid trust is intended to benefit a foreign person then the trustees should ensure that funds are available to meet the purchaser duty surcharge or land tax surcharge going forward.
One query raised by many people who hear of these consequences is how would the NSW Office of State Revenue (OSR) find out the relevant information to administer these surcharges, given that trust deeds are private documents. With respect to current acquisitions of NSW residential land the OSR will obtain the relevant information from the Purchaser Declaration form which a purchaser of an interest in NSW land must complete as part of their lodgement of the purchase contract for duty purposes. The Purchaser Declaration form expressly asks a trustee whether any of their beneficiaries is a foreign person with a substantial interest in the trust. A discretionary trust that has at least one foreign person discretionary beneficiary should answer yes to this question. Given the arcane nature of the ‘foreign person’ definition it may be that many Australian resident trustees have been answering this wrongly as ‘no’, since they would never have dreamed that Aunty May in outer Mongolia who they have not seen in years, would cause the trust to be a foreign person.
The information provided in the Purchaser Declaration form is likely to be cross checked with the information provided by the vendor as part of the land tax clearance certificate process. NSW vendors are required to obtain a land tax clearance certificate as part of the sales process, and are required to provide information on the land transaction including the details of the vendor and purchaser and their tax residency status. The information gathered by the OSR on property transactions will be shared with the Australian Taxation Office (ATO) as part of Commonwealth reporting requirements enacted late last year. Such information would assist the ATO to administer compliance with capital gains tax (including the new foreign resident capital gains withholding) and Foreign Investment Review Board (FIRB) obligations of foreign investors.
With respect to discretionary trusts that hold existing NSW residential land, it would likely be only on audit that the OSR would discover a land tax surcharge liability. Such an audit would not be difficult for the OSR, those in the industry may recall the ‘fixed trust’ audits where a copy of the trust deed and details of unitholders were requested. A similar version of audit could be done for discretionary trusts (who can be easily identified as they do not benefit from the tax-free threshold) by simply posing the questions outlined in the Purchaser Declaration form.
The problem that the FATA definition of a ‘foreign person’ causes for discretionary trusts is not a new one. The problem has existed for years in relation to the FIRB rules. One suspects that many Australians with discretionary trusts have not complied with the FIRB requirements to obtain approval before buying Australian real estate, since many would be unaware that the trust is a ‘foreign person’. There has been lobbying to amend the ‘foreign person’ definition to prevent this inadvertent consequence. If this lobbying bears fruit then the discretionary trust issue with purchaser surcharge duty and land tax surcharge may be resolved. However, at this point it is unclear when, if ever, the ‘foreign person’ definition will be amended.
The NSW purchaser duty surcharge and land tax surcharge forms part of a general theme across the Eastern seaboard of imposing extra duty and land tax on foreign investors. For a detailed discussion on this issue covering NSW, Queensland and Victoria see our previous article: Foreign Investor Surcharge – Additional tax payable by foreign purchasers of residential land.
Queensland and Victoria have different land tax regimes which charge higher land tax rates based on the concept of an ‘absentee owner’ that can catch foreign investors. The discussion in this article is not transferable to these other land tax regimes since they have their own ‘absentee owner’ definitions.
This publication covers legal and technical issues in a general way. It is not designed to express opinions on specific cases. It is intended for information purposes only and should not be regarded as legal advice. Further advice should be obtained before taking action on any issue dealt with in this publication.